## **Learning Outcomes**

After reading this article, you should be able to explain the efficient market hypothesis (EMH) and its implications for business valuation. You will be able to distinguish between different forms of market efficiency, relate behavioural finance challenges to traditional views, and critically assess the impact of market efficiency (or lack thereof) on valuation techniques. You will also be able to evaluate the role of information in pricing, identify limitations, and apply these concepts in ACCA AFM exam scenarios.

## **ACCA Advanced Financial Management (AFM) Syllabus**

For ACCA Advanced Financial Management (AFM), you are required to understand how the regulatory and market environment contributes to business valuation. In particular, you should be proficient in:

- Explaining the different forms of market efficiency and how these affect share prices and valuation methods
- Assessing the efficient market hypothesis (EMH) and its practical limitations, including behavioural finance challenges
- Evaluating the role of information in capital markets and its incorporation into security prices
- Discussing the implications of market efficiency (and inefficiency) for business appraisal and investment decisions
- Understanding how mispricing and anomalies may impact value calculations and strategic recommendations

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which form of market efficiency suggests that all publicly available information is reflected in current market prices?
   a) Weak-form  
   b) Semi-strong form  
   c) Strong-form  
   d) Market-form

2. True or false? According to EMH, it is possible to consistently achieve above-average returns by analyzing past share price movements.

3. Briefly explain how behavioural finance challenges the notion of rational market participants assumed by EMH.

4. When valuing a company using P/E multiples, what is a critical limitation if the relevant capital market is not fully efficient?

## **Introduction**

Market efficiency is a core principle supporting modern financial theory and valuation. The efficient market hypothesis (EMH) proposes that securities in well-functioning capital markets rapidly and accurately reflect all relevant information in their prices. This has significant significance for financial management, as it shapes how managers, investors, and analysts value businesses and make strategic decisions.

This article examines the different forms of market efficiency, introduces the efficient market hypothesis, reviews main criticisms (including those from behavioural finance), and discusses practical implications for company valuations. By understanding how and when market efficiency breaks down, you will be better placed to evaluate business value across different regulatory environments.

> **Key Term: Efficient Market Hypothesis (EMH)**
> The theory that security prices fully and instantaneously reflect all relevant available information, making it impossible to consistently outperform the market except by chance.
>
> **Key Term: Forms of Market Efficiency**
> Classification of how much information is reflected in asset prices: weak-form (historic data), semi-strong form (publicly available information), and strong-form (all information, including insider).

## FORMS OF MARKET EFFICIENCY

The concept of market efficiency can be categorised into three principal forms, each relating to the degree of information reflected in market prices:

### Weak-Form Efficiency

In a weak-form efficient market, current share prices reflect all information contained in the history of past trading prices and volumes. As such, technical analysis or use of historic data alone should not provide excess returns. Market participants cannot make systematic profits from trends or past price patterns.

### Semi-Strong Form Efficiency

Semi-strong form efficiency asserts that share prices incorporate not only historical price data but all publicly available information (e.g., earnings, economic data, company news). In this scenario, neither technical analysis nor fundamental analysis of public information should enable consistent outperformance.

### Strong-Form Efficiency

The strongest form claims that all information—public and private (including insider and confidential company information)—is incorporated into share prices. Not even insiders could achieve abnormal returns using privileged information in such markets.

### **Worked Example 1.1**

A company is about to announce an unexpectedly high set of earnings. Describe how this information should be reflected in its share price under each form of efficiency:

> **Answer:**
>
> - Under **weak-form efficiency**, the price may not fully adjust until trading patterns reveal the earnings announcement's impact.
> - Under **semi-strong form efficiency**, the share price will adjust immediately once the announcement is made public, so no excess profit can be earned by acting on the news.
> - Under **strong-form efficiency**, the price would already reflect the impending announcement, as even insiders' knowledge is incorporated.

## IMPLICATIONS FOR VALUATION

If markets are efficient (especially in the semi-strong form), then current market prices offer the best unbiased estimate of a company's value. This has key consequences:

- Current share price is considered a reliable input for market-based valuation methods, such as price-earnings (P/E) multiples.
- It is not possible to consistently "beat the market" through analysis of either past prices or public information.
- Active portfolio management strategies aimed at generating abnormal returns are unlikely to succeed in the long run.

However, if a market is not fully efficient, prices can diverge from true value for extended periods, and valuation models based solely on market data may misstate a company's worth.

> **Key Term: Market Anomaly**
> Patterns or events that contradict the predictions of market efficiency theory, such as persistent above-average returns from certain investment strategies or calendar effects.

### **Worked Example 1.2**

A company is considering a rights issue. In an efficient market, how should the anticipated issue affect its current share price?

> **Answer:**  
> If the market is semi-strong efficient, the share price will immediately adjust to expected dilution and other effects as soon as the rights issue is publicly announced. Attempting to react after the announcement provides no profit advantage to investors.

## BEHAVIOURAL FINANCE AND CHALLENGES TO EMH

The efficient market hypothesis assumes that all participants act rationally when processing available information. However, empirical studies and market events show that investors often behave irrationally, leading to anomalies and deviations from efficiency.

> **Key Term: Behavioural Finance**
> The study of psychological influences and biases affecting investor behaviour and resulting in pricing anomalies or market inefficiencies.

Common behavioural biases include:

- **Herd behaviour:** Investors mimic actions of the majority, sometimes driving bubbles or crashes.
- **Overconfidence:** Belief in personal ability to predict price movements, leading to excess trading.
- **Anchoring:** Relying too heavily on one piece of information (e.g., historic high price).
- **Loss aversion:** Stronger reaction to losses than gains, potentially leading to risk-averse or risk-seeking choices.

> **Key Term: Herd Behaviour**
> A tendency of individuals to align their trading decisions with those of the majority group, regardless of their own analysis.

### **Worked Example 1.3**

How could behavioural finance explain a sudden market crash not triggered by new public information?

> **Answer:**  
> Market participants may become influenced by fear or mimic others' actions, causing a rapid sell-off—even in absence of objective, value-changing news. Such moves are inconsistent with EMH's prediction that only new, relevant information affects prices.

## IMPLICATIONS FOR EXAM AND PRACTICE

For valuation in ACCA AFM, understanding market efficiency is critical:

- In fully efficient markets, trust current market prices and use them directly in models.
- In less efficient markets (e.g., emerging markets), adjust or supplement valuations for potential mispricing.
- Be aware that mispricing presents both risks and opportunities but is difficult to exploit consistently.
- Recognise behavioural finance as a reason for anomalies and temporary mispricing, but do not assume permanent arbitrage opportunities.

### **Revision Tip**

Review recent real-world examples of price bubbles, crashes, or persistent anomalies. Consider how these events diverge from EMH and what that means for real-world valuation.

### **Exam Warning**

Do not assume share prices in all markets always represent fair value. In some environments, especially where markets are less liquid or information dissemination is poor, significant and lasting mispricing can arise.

## **Summary**

Market efficiency forms the basis for modern valuation approaches, but its assumptions are not always met in practice. The EMH provides a useful framework for discussing when market prices should be relied on and when caution or further analysis is required, especially where behavioural factors or regulatory differences affect information flow and pricing.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define the efficient market hypothesis and different forms of market efficiency
- Explain implications of market efficiency for business valuation and share price analysis
- Identify major behavioural finance biases and how they challenge EMH
- Assess practical impacts on investment decisions and valuation in both efficient and inefficient markets
- Recognise limitations and risks when using market prices as inputs for valuation

## **Key Terms and Concepts**

- Efficient Market Hypothesis (EMH)
- Forms of Market Efficiency
- Market Anomaly
- Behavioural Finance
- Herd Behaviour

Regulatory and market environment - Market efficiency and implications for valuation